Package Limits Real-estate Incentive

Nation's Housing

WASHINGTON — If you invest in small-scale rental homes, condos, land, apartment buildings or other forms of profit-yielding real estate, you just lost a key battle on Capitol Hill.

The Bush administration and House Democratic tax writers pushed through a surprise legislative package last week that would significantly limit one of the most popular, widely used real-estate incentives: tax-free exchanges of "like-kind" properties.

The House Ways and Means Committee approved a toughened definition of what constitutes "like-kind" real estate, for inclusion in the l989 federal tax bill. The new standard would eliminate large numbers of transactions that currently qualify for favorable tax treatment, thereby raising tax burdens on sellers blocked from exchanging. Unless knocked out of the legislation on the House floor or in the Senate, the new standard will become law this year.

Here's what happened on Capitol Hill and what it may mean to you financially:

Under Section 1031 of the Internal Revenue Code, no gain or loss is recognized for federal tax purposes when the owners of "like-kind" properties held for investment or business purposes exchange them. For decades, "like-kind" has been broadly defined in the statute to encompass a wide variety of real estate: Rental homes could be swapped for farm land, resort condominiums exchanged for vacant suburban lots, an apartment building for a mountain top.

Exchanges have not needed to be simultaneous, either. As long as a taxpayer identifies an intended exchange property no more than 45 days after relinquishing his current property, and acquires the exchange property within 180 days, the exchange should qualify.

The object of all such swaps has been tax deferral. Even if your real estate doubled or tripled in value during your ownership, you wouldn't be subjected to federal taxation on your gains as long as you exchanged it for like-kind real estate with the same "basis" (cost for tax purposes). There is no limit to the number of exchanges you can do, provided you follow the rules and do not "sell" your property for money.

Nor has there been any requirement that you ever be taxed on your investment property's gains during your life time. You can will your real estateto your heirs, who take it over at its then-current value (or "stepped-up basis").

Your heirs' tax liability is limited to the gains in value on the real estate occurring during their time of ownership, not the big profits racked up during yours.

Although part of the federal code since 1924, tax-deferred exchanging has surged in popularity following the Tax Reform Act of 1986.

The reform law eliminated cut-rate capital gains and thereby raised the effective tax rates on real-estate sales by everyone, from mom-and-pop rental-home investors to the richest corporations. Sellers who would have paid no more than 20 percent taxes on their gains prior to 1986 find the bite to be 28 or 33 percent today.

Hence the rapid growth nationwide of exchanging. An entire sub-industry of exchange brokers, "facilitators," real-estate attorneys, title insurers and other professional intermediaries now exists to handle swaps among investors coast-to-coast.

The toughened standards on "like-kind," however, could put a damper on exchange activity. The Ways and Means Committee revision would restrict real-estate swaps to those involving properties that are "related in service or use."

A farmer looking ahead to retirement, for instance, no longer could exchange his acreage tax-deferred for income-producing rental housing in the Sun Belt. A rental-home investor couldn't swap for part-ownership in a community shopping center. A small business owner couldn't exchange his retail store property for a garden apartment.

"It's a very significant and a very sudden change," said a top tax-law expert on exchanging, Howard J. Levine, a Washington-based partner with Roberts and Holland.

"It will definitely hurt," said Robert Egenolf, president of First Exchange Corp. of Santa Barbara, Calif., a firm that arranges swaps from $100,000 to $30 million. "One of the great advantages of real-estate exchanging has always been its flexibility. This will cut back on that and reduce (exchanging's) appeal."

Egenolf said that many property owners may be discouraged from even considering an exchange for fear they'll be restricted by Uncle Sam to virtual clones of their present holdings.

Real-estate trade lobbies in Washington - stung by the "sneak attack," as one official put it - are mapping plans to fight the change for the balance of the tax bill's legislative process.

Lining up against it most prominently are the 800,000-member National Assn. of Realtors (NAR) and the National Realty Committee (NRC).

The latter group represents a small but elite segment of the nation's largest commercial property owners.

The main argument against the standard change will be economic: At a time when real estate in many markets already is in a weakened condition because of overbuilding and the 1986 reforms,

"This is no time to make things even less attractive to investors," said a lobbyist.

That argument is expected to have special meaning in the Senate, where the top tax writer, Lloyd Bentsen (D-Texas), chairman of the Finance Committee, has expressed strong opposition to further anti-real-estate tax-code changes.

But can Bentsen block his fellow Democrats in the House and his fellow Texan in the White House on real-estate tax reform in 1989? Stay tuned.